Thursday, 14 January 2010

Stock Option Ethics

There are five important ethical issues to consider when adopting stock option plans into an organization; these issues are outlined considerably below: Backdating stock options; Expensing Employee Stock Options can result in improper accounting; Over issuing of Stock Options; Backdating stock options and tax implications; and Spring loading/Bullet dodging. (1) Backdating stock options: Backdating happens when a particular organization grants employee stock options to their executives or employees on a day where the organizations share price was lower than the actual market share price approved by the shareholders as outlined in the shareholders approved stock options document. This process is not necessarily illegal, although the four conditions which will be discussed later are often never satisfied in determining when backdating is in fact legal. Backdating becomes illegal when organizations investors are misled as a result of the backdating activity. As mentioned earlier, public companies generally grant stock options in accordance with a stock option plan approved by shareholders which often takes place in an annual meeting. In most cases organizations' stock option plans provide that the employee stock option must be granted at an exercise price no lower than the option grant estimated at fair market value on the date of. For example, company ABC grants stock options on May 1, and the initial stock price is $50, but ABC decides to backdate these options to April 15, when the price was only $40, this makes the option grant more appealing to the grantees. Since the grants were actually made on May 1, and the strike price of the granted stock options is $40, not $50, this would then be below the fair market value. This example is an appropriately apposite illustration that suggests backdating can in fact be misleading to the shareholder, because the stock options granted are at a more favorable rate to the grantees then what was predetermined by the shareholders approved stock option plan. Backdating allows executives to choose a past date when the market price was particularly low, thereby inflating the value of the options. Companies must disclose such maneuvers to investors and board members. It could possibly be illegal when they have not fully disclosed their actions to the shareholders. Backdating is not illegal so long as this criterion is satisfied: No documents have been forged; Backdating is clearly communicated to the company's shareholders; Backdating is properly reflected in the companies reported earnings; and backdating is properly reflected in taxes. [Lie, 2006]

(2) Expensing Employee Stock Options may result in improper accounting: Backdating can lead to misleading the investors in relation to the way the company accounts for the stock options granted in their financial recordings. If an organization granted options with an exercise price lower than fair market value, according to applicable accounting rules, the company would have to recognize this as a compensation expense. It should be noted, that if the stock option was granted to an executive or an employee at fair market value then the organization would not have to recognize this cost of the stock option as a compensation expense. By failing to record the backdated stock option as a compensation expense, the organization's accounting information may in fact be incorrect resulting in the company's annual and quarterly financial reports to investors to be indeed misleading. It has been reported that the company's top level executives have tried to actively pursue concealing the backdating of stock options by falsifying corporate documents which inadvertently shows an exorbitant exaggeration of the company's profitability.

(3) Over-issuing of stock options: Ample issuing of stock options has created a link which makes it easier for companies to funnel profits directly to employees - in most cases those top executives - at the shareholders expense. Cisco Systems for example, executives and employees have in total pocketed gains of $24 billion over 12 years. Cisco has spent $19 billion in buying back shares to help stabilize the output impact of the options compensation. In the last 12 years Cisco has not paid out a single cent in dividends. The over issuance of stock options to executives and employees is a clear abuse to the shareholders, because the money that went into the stock options could have been diverted to the shareholders in the form of dividends.

(4) Backdating stock options and tax implications: Backdating employee stock options can create tax problems for companies especially their executives and employees. Often backdating leads to misreporting of corporate taxable income, misreporting of employees wages and incorrectly withholding federal income taxes and Federal Insurance FICA taxes. Innocent executives are the ones who will most likely take the fall for those guilty parties backdating stock options. When this happens in most cases back taxes will be owed with a high probability of paying significant interest and penalties. Greg Reyes, former CEO of Brocade, was convicted in August 2007, found guilty of ten counts of conspiracy and securities fraud. He was sentenced to serve a twenty consecutive year prison term. The backdating that occurred at Brocade saw Brocade stock price soar from May 1999's split adjusted price of $8.05 jump to $133.71 which is an improvement of some 1,659%. Shortly after the restatement, the stock price dropped significantly to a mere $3.34. [Alexander, 2007]

(5) Spring Loading / Bullet dodging: Spring-loading is when a company's executive(s) time an options grant to precede good news pertinent to the organization they work within. This audacious move anticipates the rise in the company's stocks price and attempts to increase the value of the stock option. Spring loading is illegal so far that the company's shareholders are in possession of the same knowledge of the executives. If both parties do not have equal knowledge of this good news, it could very well be a violation of insider trading rules. Bullet dodging is where company executives delay stock option grants until just after the release of bad corporate news. This often results in a companies stock declining. This is one variant of back dating that is almost impossible to prosecute those guilty executives of insider trading.